As interest rates are at levels not seen in decades, there has been greater attention to low-risk, fixed-income investments like Guaranteed Investment Certificates (GICs). However, there may be a tax-efficient alternative that is worth consideration: the discount bond.
With the rapid rise in interest rates since the start of 2022, and unprecedented bond market volatility, many quality bonds are trading at discounts to their par values. These bonds can offer a tax-efficient alternative to GICs from a risk perspective, but may provide greater after-tax return potential. This is because when a GIC is held in a non-registered account, any income earned will be fully taxable at the investor’s marginal rate — compared to capital gains and dividend income, which generally receive more favourable tax treatment. A discounted bond has a portion of the total return taxed at lower capital gains rates.
What is a Discount Bond?
First, let’s look at the differences between a GIC and a bond. GICs pay a guaranteed return, expressed as an interest rate paid on the amount invested, which is taxable as interest income in a non-registered account. Since they aren’t tradeable assets, they don’t vary in price.
At maturity, the original investment, including interest, is returned to the investor. Bonds, on the other hand, generally pay a coupon, or an annual interest rate (sometimes paid semi-annually), which is taxable as interest income. The coupon rate is expressed as a percentage of the bond’s “face value” — the amount paid to the bondholder at maturity. Over the life of the bond, a bond’s price can vary as interest rates change.
Take, for example, a 2-year, $1,000 bond issued with a 4 percent annual coupon rate, or a $40 coupon amount. Let’s say that interest rates rise for comparable bonds in the next month to 6 percent, so these bonds now offer a coupon amount of $60. As such, the bond that pays the coupon of $40 will need to fall in price so that its coupon and eventual face value paid at maturity ($1,000) will be equivalent to the new 6 percent yield. So, the bond’s price would fall to $966. When a bond is sold for less than its face value, it is termed a “discount bond.” Conversely, if interest rates fall and become lower than the bond’s coupon rate, the bond will be sold at a “premium” (or above par).
What Makes a Discount Bond Attractive?
Bonds generally mature at par, which is $1,000 in the example above. With the discounted bond, the return achieved from the discounted price paid, or $966, and its original par value, or $1,000, would be treated as a capital gain for tax purposes. The coupon amount would still be taxed as interest income. However, since a portion of the total return generated by the discounted bond is taxed at a lower capital gains tax rate, this makes the discounted bond more tax-efficient than a comparable GIC with returns fully taxable as interest income. The chart (above, illustrative) shows this scenario and the difference in after-tax returns.
In some cases, even if the GIC has a higher pre-tax expected return than the discounted bond, the after-tax returns of the discounted bond may be notably higher. In addition to the tax advantage, many quality bonds are more liquid than GICs. As well, in a situation where future interest rates decline, there may be an opportunity to realize gains before the bond reaches maturity. Since many quality bonds currently trade at a discount, investors may be able to find appropriate portfolio additions that meet their risk tolerance, while offering higher after-tax returns than GICs. To learn more, please call the office.